Many people owe tens or even hundreds of thousands of dollars, simply because they bought too much stuff! You may be in a place where your top priority is to pay off debt. While that is a noble and wise ambition, you have to be careful that you do not go about it in the wrong way.
3 Potential Mistakes To Avoid When Trying To Pay Off Debt
These three strategies may seem like a great idea at the time, but they can backfire in a hurry and can end up being huge financial mistakes.
Tap Into Your 401k
Many 401k plans will allow you to borrow from them. I have had a lot of people tell me that borrowing from their 401k was a good idea because they would just be “borrowing from themselves”. That type of thinking has many people taking out tens of thousands of dollars out of their 401k’s in order to pay off debt, or simply buy some expensive new toy (or house). They justify it by claiming that since they only borrowed from themselves, they are just paying themselves back with interest.
This may seem like a good idea at first, but their are a couple of things to consider before making this move. First, your 401k is for retirement! The point of these accounts is for you to deposit money (up to the annual 401k contribution limits) into particular funds, and give them time to grow. Time is the most important factor when it comes to investing. You may have heard the phrase, “it’s not timing the market, it’s time in the market”, which speaks to this point.
When you borrow money, you remove that balance from your retirement account, and it fails to earn interest. Imagine trying to build a huge snowball by rolling it down a hill in the snow. A little bit of snow will stick to it at first, then you pack on more snow (through additional payroll withdrawals), and it gets larger. Then it is able to cause more snow to stick to it as it rolls, this process repeats over time. You may hit a couple of flat sections in the hill, or deal with the sun coming out and melting a part of your ball; but if you stay consistent, you’ll soon have a massive snowball that is hard to stop!
40 years of creating a huge snowball would probably allow you to have provision all throughout retirement – if you allow the snow to melt slowly, giving you “water” as you need it (just be sure to choose the right withdrawal rate)! Now imagine that you want to pay off debt, and you decide to stop focusing on creating a snowball, in order to put your efforts into putting out your debt fire (I’m just full of analogies today). You have 3 choices in relation to your 401k (the snowball ;)). First, you can choose not to make any changes to your contribution levels. Next, you can allow the snowball to move down the hill with less help or no help at all (by reducing or completely removing the amount you contribute). The last option is to take out a blowtorch, melt down the huge snowball, and use the water to put out some of the fire!
You shouldn’t try to comfort yourself in the fact that as you put the snow back into place, that it’s all going toward your snowball. But instead, you should be angry at all of the growth that you are missing out on, because you destroyed, or significantly reduced the size of, your snowball. For as long as our money is not in our retirement account, we miss out on all the gains on that money, as well as the added returns on those gains!
Also, many jobs (or plan administrators) will require that you pay back the loan in full within 60 or 90 days of leaving the job. If you are not able to pay back the loan within that time, then you will have to pay taxes on the amount not repaid, as well as a 10% early withdrawal penalty! With the economy in the middle of a decade-long downturn, and more employers depending on the contingent workforce, it is not a good idea to put yourself in a position to have to repay a five-figure debt if you lose your job!
My advice would be the same whether you are talking about a current IRA or 401k, or even a retirement account from a former job.
Of course, there are times where it is best to take out a loan, but only in extreme cases. You should try to find ways to reduce your expenses, bring in more income, and seriously change your lifestyle. Only after you have exhausted all of these avenues should you even look at your retirement accounts!
Using Your House As An ATM
In the middle of the prior decade, it became fashionable (and pretty much expected) to borrow against the equity in your home. People began to use their homes as an ATM – pulling money out in order to buy cars, make costly upgrades to the home, and even pay for their kids’ tuition! Thankfully, those days are pretty much over, as reality has begun to set in for many foolish homeowners.
However, there are still a good number of people considering using the equity in their home to consolidate their debt. You may look at the fact that you have a lower interest rate on your mortgage and get tempted to take out a home equity loan to pay off your debt.
This can be a great move if you plan to stay in the home and aren’t forced to sell early – due to financial hardships, or the need to move. However, if the value of your home drops, and you are in a position where you have to sell, you could be in serious trouble. If you run into financial trouble, then you risk going into foreclosure and losing your home. This is far worse than only being able to pay the minimum against your credit card bill.
Rather than seeing the equity in your home and “free money”, you need to consider it to be a cushion against falling home prices. If you are careful to evaluate your situation, and disciplined enough to leave a fair amount of equity, then consolidating your debt may be a wise move. Unfortunately, it can lead to disaster for many, so I would caution people to perform a serious and unbiased analysis – with a financial adviser if necessary – before making this decision!
Pay Off Debt By Borrowing From Friends Or Family
You all know the dangers of borrowing from a loved one. It can destroy your relationships, and many times, it isn’t worth it. Even if you are paying back the loan according to the terms which you agreed upon, bitterness can still set in. This is especially true if they see you making purchases that seem questionable in their mind. They may wonder how you are able to buy that item, or go on vacation, but you aren’t able to pay them anything extra.
If you run into trouble and are not able to pay them back on schedule, their reaction could be even worse. This is a very tough decision to be faced with, but I would advise approaching the idea of borrowing money from a loved one with extreme caution.
This post was written by Khaleef who currently owns and operates, KNS Financial and Fat Guy Skinney Wallet. He is an excellent writer and often focuses on personal finance topics just like me! Take a look at his sites and if you like what you see, make sure to subscribe.
photo by Nutdanai Apikhomboonwaroot
- What are some of the most creative methods you used to pay off debt?
- If you are still in debt (yes, a mortgage loan is debt), how aggressive are you in paying it back?
- What are some of your financial decisions that have backfired?
- Would you ever borrow money from a loved one? If so, how would you safeguard against hard feelings?